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The comprehensive report of Lehman Brothers Holdings' path to bankruptcy that bankruptcy examiner Anton Valukas released yesterday is stunning in its depth and breadth. It details so many repeated, deliberate material misstatements the firm made in securities filings and public statements about its financial condition that former Chief Executive Officer Richard Fuld and former Chief Financial Officer Erin Callan will almost certainly face criminal charges, and former CFOs Chris O'Meara and Ian Lowett quite possibly could as well. Indeed, if the information in the report is true -- and Valukas reviewed millions of documents, conducted over 100 interviews and thoroughly footnotes his report -- it's hard to see how they can escape conviction.

In an interview with Bloomberg TV, former Lehman CFO Brad Hintz said all brokerage firms would bring down their balance sheets at quarter's end by selling securities, but that doesn't address the issue here. The Valukas report says Lehman under Fuld was essentially faking sales and using the "proceeds" to pay down liabilities. Since the transactions weren't really sales, the liabilities weren't really decreasing. The firm had simply borrowed cash for a week or so and used it to temporarily pay down liabilities. Massive amounts of these transactions would occur straddling quarterly reporting periods so that balance sheets reported publicly would reflect the benefit of the apparently paid-down liabilities.

Hintz confirmed on Bloomberg TV that no other firms were using the so-called Repo 105 transactions that constituted Lehman's purported asset sales.

What Did Fuld Know?

By fourth-quarter 2007 and continuing through the first and second quarters of 2008, the impact on the balance sheet was clearly material based on Lehman's own definition of materiality, and thus by law had to be disclosed.

Hintz was asked on Bloomberg TV if Fuld was a hands-on executive or not (Fuld's attorney's claims that the CEO was a remote manager and didn't know what was going on). Hintz replied that while he was at Lehman, Fuld was very hands-on, and Valukas's bankruptcy report cites several sources to show Fuld knew about Repo 105.

If Fuld and any other CFO did know about the Repo 105 transactions at the times Valuka's report asserts, they may face criminal charges under Sarbanes Oxley, too. A key Sarbanes-Oxley reform requires executives to certify their company's financial statements' accuracy at the risk of criminal and financial liability, although the penalties apply only if the executives had actual knowledge or worked really hard to avoid knowing.

How Repo 105 Worked

Repo 105 looked just like an ordinary repo transaction. Lehman would give the counterparty highly liquid securities in exchange for cash, and then repay the cash plus interest and get the securities back.

But Repo 105 had two key differences from an ordinary repo transaction. First, Lehman had to pay much more interest -- 5% instead of the normal 2%. Second, because it paid that extra interest, Lehman used a different accounting treatment. Instead of booking Repo 105s as financing transactions, which added to both assets and liabilities and had no net impact on Lehman's balance sheet, Repo 105s were booked as sales, and the proceeds were used to pay down liabilities.

In order to execute Repo 105 transactions, Lehman had to route the trades through its British affiliate, Valukas's report says, because no U.S. law firm would give a legal opinion that Repo 105 transactions in fact met the requirements for a sale accounting treatment. However, Linklaters in England opined that under English law, the transaction could qualify as a sale.

Thus, the accounting in the U.S. relied on the accounting of the British affiliate -- an accounting treatment Lehman knew it couldn't get in the U.S. directly. Indeed, contemporaneous emails and documents cited by Valukas show that Lehman believed no other firm was using similar transactions. Nor did Lehman tell its outside counsel, Simpson Thatcher, about its use of Repo 105.

Well Hidden From the Unsuspecting

Numerous emails, other documents and interviews cited by Valukas show that key executives from Fuld down knew about Repo 105's use and its purpose of improving the balance sheet's appearance. As Lehman's problems developed in 2006, 2007 and 2008, Repo 105 was used with increasing frequency. People within Lehman even spoke of things getting "105'd."

Nonetheless, even a careful review of Lehman's 10Qs and 10K wouldn't have revealed its use. When analysts questioned former CFO Callan about Lehman's leverage and liability reductions, she would talk of asset sales and imply that the sales were of real estate securities and other less liquid assets. She didn't reveal the Repo 105s or the fact that they only involved highly liquid assets. According to the report, Lehman's board of directors was also kept in the dark about Repo 105 use.What about Lehman's auditor, Ernst & Young? In interviews with Valukas the firm essentially claims it did nothing wrong but that it only tacitly acquiesced in the Repo 105 accounting, agreeing with its theoretical construction but never evaluating or blessing actual transactions. Nor did Ernst & Young ever audit a Repo 105 transaction or assess the impact of the volume of them on the balance sheet.

However, Valukas concludes that a "colorable" claim exists that Ernst & Young is guilty of professional malpractice for its failure to object to Repo 105's accounting and lack of disclosure, as well as its failure to otherwise assess the impact of Repo 105 on Lehman's financial statements. Valukas makes clear that his use of the "colorable" claim rises above the standard definition of sufficient to survive a motion to dismiss. He claims that the information he discovered, unless defeated by a defense he didn't investigate, would be sufficient to find the claim true, i.e. that malpractice did indeed occur.
Out to Avoid a Ratings DowngradeBy 2007, both the market and ratings agencies were focused on financial firms' leverage ratio and balance sheets as key indicators of health. Unfortunately for Lehman, a massive growth strategy it had embraced in 2006 had jacked up its leverage ratio and filled its balance sheet. As Valukas details, had the markets or ratings agencies known Lehman's true condition, the firm would have faced a ratings downgrade -- and major market consequences. So, Lehman focused on improving its balance sheet and reducing leverage.

Lehman had only two ways to do that: sell assets or raise capital. Instead, Lehman simply used Repo 105 to make it appear it had fixed things. Since Lehman's assets were "sticky," meaning they would have to be sold for far less than Lehman had valued them on its books, Lehman didn't dare sell many assets. Since raising capital brought its own perception problems -- and eventually the amount of capital that Lehman had to raise was prohibitively enormous -- Lehman increasingly turned to Repo 105.

The Valukas report notes that not everyone within Lehman was content to use Repo 105 to cook the books. In particular, Bart McDade and Matthew Lee stand out. McDade tried hard to get a cap put on Repo 105's use, and when he was eventually promoted to a position with sufficient power, he did so himself. By then, however, it was much too late.

Similarly too late but nonetheless important, Senior Vice President Matthew Lee wrote a letter to management alleging accounting improprieties and triggering an investigation. Unfortunately for Lehman, Ernst & Young conducted the investigation and did not report the allegations to Lehman's Audit Committee despite specific instructions from the Audit Committee.

Editor's Note: We'll be further reviewing the Valukas report and laying out its findings and their implications in follow-up stories.